What’s With All this Paperwork, Part VIII: Loans with Security Interest

Hey everyone, pardon the delay for this week’s Draw the Law, but many of my clients have been requesting services preparing for the end of the year or getting ready for the coming year.  How about yourself? Do you have New Year resolutions concerning the conduct of your business? Better policies? New agreements? Finally, converting that sole proprietorship into a business entity like a limited liability company or corporation?
Whatever it may be, just remember you will inevitably need good documentation and record keeping, so be sure to set-up a good process for storing all your data and information.

Anyway, let’s get back to Draw the Law, which we are still covering paperwork you may see starting a business.  Last week, I covered a promissory note with a balloon payment type of structure.  Recall, that this is a transaction whereby the loan is paid off by making small  payments throughout the term of the note, but has a large “balloon” payment in the end of the term. Today’s topic is still about loans, but this one focuses on the use of a security interest.  This method is used to provide greater assurances to a lender by providing collateral from the debtor.

So How does this Work?

Typically, a promissory note shall state that there is a secured interest in the promissory note.  It will state who the lender is, the personal property items that a security interest is attached to, and the borrower’s business. In addition, the promissory note commercial lenders, such as banks will prepare additional documentation, usually a security agreement.  If this is an agreement between you and a friend, family, or some other person you and the lender will need follow up on these details.

The security agreement outlines that grantor (the debtor) has assigned a security interest to the grantee (the lender in the transaction) with respect some sort of collateral (the personal property that is being secured for the loan).

Typically what happens is if your business goes under and is unable to repay the loan, the lender now has the right to recover the collateral as a means to satisfy the debt.

So the debtor (black) will put up some kind of collateral (the machine) for a loan (black agreement) for money (in green).  However, if repayment fails (in black) the lender (the bank) has a security agreement (in red) securing the collateral. Further, the lender will notify the public of its secured interest in the machine by filing a UCC-1 statement with the proper agency (in blue).

What Works as Collateral?

Almost anything can work as collateral.  It can be tangible items, such as equipment, fixtures, inventory, but can also be intangibles, such as accounts receivables, patents, or promissory notes owed to you.  However, be aware that the lender will consider the cost and expenses of trying to collect the item, its value after use, the size of the loan, etc . . . and various other factors when even deciding if your collateral is sufficient for the size of the loan.  The special machine you imported from Italy may cost you a huge chunk of money, but if you go out of business the bank will have to find a buyer and may have to rip it out of your store as well so that may not be worth a whole lot to the bank.

When going for a secured transaction (a loan with a security interest) be aware of what you are putting up as collateral.  It may be valuable to you, but the lender giving you money needs to figure out how to extract value from the personal property should you go under to recoup the loan given to you.

Further Documentation by the Lender: The UCC-1

This whole process of securing a loan via a security interest is basically a method for the lender to secure their spot among creditors and know for certainty if your business fails where they are in line against other creditors as to extracting value from the defunct business.  Without getting into a subject matter that law students dread studying for the bar exam, understand that a UCC-1 financing statement (UCC stands for Uniform Commercial Code) may be completed by the lender, which is then filed with the appropriate state agency with regard to the property that has an interest attached to it. This serves as notice to future creditors that the lender holds a lien on the listed assets. However, if your business is successful and can pay off the loan you should make sure that a release is filed in the same public office where the original UCC-1 was filed.

Last Word: Background Check for Buying Businesses

As this is the end of the year, I would like to recognize many people view the New Year as a time to begin new adventures, such as starting a business.  However, remember long ago rather than from starting from scratch you may consider buying an established business.  Why am I bringing this up?  Well, you just learned about security interests whether you are doing an asset purchase or an entity purchase it is wise to do some research.  Sometimes that research includes digging through UCC-1 filings to make sure the business or its assets that you want to buy don’t have outstanding loans or security interests on them.

This is the last Draw the Law post for 2012. Check back in the beginning of next year for new posts!

*Disclaimer:  This post discusses general legal issues, but does not constitute legal advice in any respect.  No reader should act or refrain from acting based on information contained herein without seeking the advice of counsel in the relevant jurisdiction.  Ryan K. Hew, Attorney At Law, LLLC expressly disclaims all liability in respect to any actions taken or not taken based on the contents of this post.

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